Sam Bacevich explores economic growth policy in developing nations.
David Ricardo’s theory of competitive advantage demonstrates that trade increases consumption for participating countries — subsequently his theory has dovetailed into current neoliberal trade policy. In the 21st century, Ricardo has largely been proven correct. International trade’s success has dragged millions of people across the globe out of poverty and into the middle class. However, it has also left many countries that represent an essential link in the global supply chain with a cyclical dependency on commodities and low domestic consumption. Increasing human capital and technological spillover, once touted as a byproduct of free trade and foreign direct investment (FDI), have created very little sustainable domestic growth and a stagnant middle class for many nations who pinned their developmental goals on an export oriented economic model. The current philosophy, which is widely purported by developed countries and the multilateral institutions they fund, overemphasizes immediate market access and FDI as the solution to a country’s woes. To grow the global middle class, each individual country must test their own economic model to create sustainable domestic growth and a sizeable middle-class consumer.
FDI May Not Be the Answer
In the 1970’s, developed nations began pivoting away from foreign aid, favoring investment by large multinational corporations (MNCs) and freeing up trade. While lump sums of money seemed to create negative externalities within countries, economists and politicians hoped that interactions between developed and underdeveloped nations would have spillover effects that would create long-term economic growth. In this model, MNCs would enter a country to take advantage of low labor costs or access a commodity, and the host country would benefit from state of the art technology and efficient management practices. In theory, the technological advancement is a principle driver of economic growth, so the entry of the MNCs into emerging markets should begin to facilitate a convergence of developing and developed countries. Effectively, economic growth, through the FDI from MNCs, would drag the majority of a developing nation’s population into the global middle class.
However, this model fails to incorporate the truly expansive supply chains that are now typical of large corporations. MNCs often source materials from multiple countries, and choose another country for final assembly. They invest only enough to satisfy the requirements of their supply chain. FDI, and the technological expertise that follows, flows towards a singular sector, rather than the broader economy. This creates an environment in which one sector represents a significant portion of FDI stock, economic productivity, and educated human capital. Subsequently, a country that specializes in one sector is now largely dependent on that sector’s success, which exposes their domestic economy to potential market volatility. For example, numerous African and South American nations are specialized suppliers of raw materials for MNCs, but they have not seen an increase in domestic wealth. By 2030, only 8% of the global middle class will come from both continents combined.
Currently, the notion that FDI will still be an enormous advantage even when it is focused within a single industry is widely accepted and celebrated. However, numerous studies show that there are barriers to long-term economic growth from FDI. FDI’s benefit is closely tied with the education level of the working population of the country. If a country lacks the human capital to adopt and adapt to technology, then technological adoption will eventually hit a ceiling where no more advancement is possible. The lack of technological spillover may even have a negative effect as domestic firms cannot compete with their international rivals, and are forced out of business.
The Two-Tracked Growth Model
A successful domestic middle class attracts FDI into a larger variety of domestic sectors, creating a more diversified economy, which can withstand volatility in any single market. According to the OECD, the global middle class consumer is defined as anyone who has a spending power between $10 and $100 dollars a day. Additionally, nearly 85% of the middle-class growth is predicted to come from Asia, which currently has a significant portion of its population living just below the $10 a day threshold. The emergent global middle class will push consumption up from $21 trillion to about $56 trillion by 2030, with only about a fifth of this growth coming from North America and Europe. The middle-class threshold is also when many families begin seeking more advanced education, which directly benefits the amount of technological absorption within the host country.
This begs the question: what have Asian countries done differently than the rest of the emerging world? Predominantly, almost all economically successful Asian nations have followed a two-tracked economic growth model. This model starts by protecting important domestic businesses with high tariff restrictions while simultaneously establishing special economic zones (SEZs) across the country to attract foreign investment. As domestic businesses become strong enough to compete with MNC’s within their domestic markets, these tariff restrictions are slowly removed. SEZs also allow for the slow diffusion of technology because MNCs still hire from the local population. As of 2012, India had 143 SEZs in operation and another 634 that are either approved or under construction. In 2016, India began repealing tariffs protecting their airline, defense and pharmaceutical industries. Until Prime Minister Modi deregulated, even Apple — which is ubiquitous in other countries around the world — could not open a branded store. Subsequently, India’s middle class has reached a population of 267 million, and has become the darling of global consumer goods companies.
A Tale of Two Countries
To illustrate the point, let us take two countries: Country A and Country B. Country A maintained import monopolies, kept tariffs on agricultural and industrial products as high as 50%, and refused to register as a member of the WTO until 2007. Country B has long been a member of the WTO, slashed tariffs to a maximum of 15% and received a commendation from the US State Department for reducing barriers to trade. Country A had GDP growth rates exceeding 8%, sharply reduced poverty and attracted significant FDI. Country B still has a declining middle class, poor social indicators and does not see significant trade flows despite its open market access.
Country A is Vietnam, which has followed a two-track model since the 1980’s. Country B is Haiti, which sharply reduced trade barriers in the early 1990’s, yet remains one of the poorest nations in the Western hemisphere.
Since Vietnam joined the WTO in 2007, FDI into the country has totaled more than $8.5bn. By 2020, Vietnam’s middle class is projected to represent about a third of the total population. Vietnam, through heavy tariff protection in the agricultural sector, is also one of the only developing Asian countries to have a significant rural middle class. While there are obviously many differences between the two economies, the disparity in economic development between Haiti and Vietnam goes some distance to exemplify that market integration is a result of successful domestic policy, and not a prerequisite for economic success.
The IMF, WTO, and World Bank often require developing countries to diminish trade restrictions before receiving financial aid or support. This umbrella response to developmental issues fails to incorporate a varied selection of domestic economic problems. Domestic protectionism can provide short term synchronized growth for a majority of the population, ensuring that a larger portion of the population will achieve middle class status. By establishing a two-track economic model, a country can address their domestic economic issues while simultaneously attracting FDI. This combination allows countries to leverage the diversity of their domestic business to weather market volatility, while also enjoying the growth associated with being incorporated into the global supply chain. As developing countries continue to drive consumption and growth in the upcoming decades, many should consider altering their trade policy to position themselves for long term, sustained growth, with a strong domestic market.